Arbitrage

From Wikipedia, the free encyclopedia

Jump to: navigation, search
Not to be confused with Arbitration.
In economics and finance, arbitrage (IPA: /ˈɑrbɨtrɑːʒ/) is the practice of taking
advantage of a price difference between two or more markets: striking a
combination of matching deals that capitalize upon the imbalance, the profit
being the difference between the market prices. When used by academics, an
arbitrage is a transaction that involves no negative cash flowat any probabilistic
or temporal state and a positive cash flow in at least one state; in simple terms, it
is the possibility of a risk-free profit at zero cost.

In principle and in academic use, an arbitrage is risk-free; in common use, as

in statistical arbitrage, it may refer to expected profit, though losses may occur,
and in practice, there are always risks in arbitrage, some minor (such as
fluctuation of prices decreasing profit margins), some major (such as devaluation
of a currency or derivative). In academic use, an arbitrage involves taking
advantage of differences in price of a single asset or identical cash-flows; in
common use, it is also used to refer to differences between similar assets (relative
value or convergence trades), as in merger arbitrage.

A person who engages in arbitrage is called an arbitrageur (IPA: /ˌɑrbɨtrɑːˈʒɜr/)—

such as a bank or brokerage firm. The term is mainly applied to trading
in financial instruments, such
asbonds, stocks, derivatives, commodities and currencies.

Contents
• 1 Arbitrage-free
• 2 Conditions for arbitrage
• 3 Examples
• 4 Price convergence
• 5 Risks
• 5.1 Execution risk
• 5.2 Mismatch
• 5.3 Counterparty risk
• 5.4 Liquidity risk
• 6 Types of arbitrage
• 6.1 Merger arbitrage
• 6.2 Municipal bond arbitrage
• 6.3 Convertible bond arbitrage
• 6.4 Depository receipts
• 6.5 Dual-listed companies
• 6.6 Private to public equities
• 6.7 Regulatory arbitrage
• 6.8 Telecom arbitrage
• 6.9 Statistical arbitrage
• 7 The debacle of Long-Term Capital Management
 • 8 Etymology
• 9 See also
• 9.1 Types of financial arbitrage
• 9.2 Related concepts
• 10 Notes
• 11 References
• 12 External links
[edit] Arbitrage-free
If the market prices do not allow for profitable arbitrage, the prices are said to
constitute an arbitrage equilibrium or arbitrage-free market. An arbitrage
equilibrium is a precondition for a general economic equilibrium. The assumption
that there is no arbitrage is used in quantitative finance to calculate a unique risk
neutral price for derivatives.

[edit] Conditions for arbitrage

Arbitrage is possible when one of three conditions is met:

1. The same asset does not trade at the same price on all markets ("the law
of one price").
2. Two assets with identical cash flows do not trade at the same price.
3. An asset with a known price in the future does not today trade at its future
price discounted at the risk-free interest rate (or, the asset does not have
negligible costs of storage; as such, for example, this condition holds for
grain but not for securities).
Arbitrage is not simply the act of buying a product in one market and selling it in
another for a higher price at some later time. The transactions must
occur simultaneously to avoid exposure to market risk, or the risk that prices may
change on one market before both transactions are complete. In practical terms,
this is generally only possible with securities and financial products which can be
traded electronically, and even then, when each leg of the trade is executed the
prices in the market may have moved. Missing one of the legs of the trade (and
subsequently having to trade it soon after at a worse price) is called 'execution
risk' or more specifically 'leg risk'.[note 1]

In the simplest example, any good sold in one market should sell for the same
price in another. Traders may, for example, find that the price of wheat is lower in
agricultural regions than in cities, purchase the good, and transport it to another
region to sell at a higher price. This type of price arbitrage is the most common,
but this simple example ignores the cost of transport, storage, risk, and other
factors. "True" arbitrage requires that there be no market risk involved. Where
securities are traded on more than one exchange, arbitrage occurs by
simultaneously buying in one and selling on the other.

See rational pricing, particularly arbitrage mechanics, for further discussion.

Mathematically it is defined as follows:

and
where Vt means a portfolio at time t.

[edit] Examples
• Suppose that the exchange rates (after taking out the fees for making the
exchange) in London are £5 = $10 = ¥1000 and the exchange rates in Tokyo
are ¥1000 = $12 = £6. Converting ¥1000 to $12 in Tokyo and converting that
$12 into ¥1200 in London, for a profit of ¥200, would be arbitrage. In reality,
this "triangle arbitrage" is so simple that it almost never occurs. But more
complicated foreign exchange arbitrages, such as the spot-forward arbitrage
(see interest rate parity) are much more common.
• One example of arbitrage involves the New York Stock Exchange and
the Chicago Mercantile Exchange. When the price of a stock on the NYSE and
its corresponding futures contract on the CME are out of sync, one can buy the
less expensive one and sell it to the more expensive market. Because the
differences between the prices are likely to be small (and not to last very long),
this can only be done profitably with computers examining a large number of
prices and automatically exercising a trade when the prices are far enough out
of balance. The activity of other arbitrageurs can make this risky. Those with
the fastest computers and the most expertise take advantage of series of small
differences that would not be profitable if taken individually.
• Economists use the term "global labor arbitrage" to refer to the tendency
of manufacturing jobs to flow towards whichever country has the lowest wages
per unit output at present and has reached the minimum requisite level of
political and economic development to support industrialization. At present,
many such jobs appear to be flowing towards China, though some which
require command of English are going to India and the Philippines. In popular
terms, this is referred to as offshoring. (Note that "offshoring" is not
synonymous with "outsourcing", which means "to subcontract from an outside
supplier or source", such as when a business outsources its bookkeeping to an
accounting firm. Unlike offshoring, outsourcing always involves subcontracting
jobs to a different company, and that company can be in the same country as
the outsourcing company.)
• Sports arbitrage – numerous internet bookmakers offer odds on the
outcome of the same event. Any given bookmaker will weight their odds so that
no one customer can cover all outcomes at a profit against their books.
However, in order to remain competitive their margins are usually quite low.
Different bookmakers may offer different odds on the same outcome of a given
event; by taking the best odds offered by each bookmaker, a customer can
under some circumstances cover all possible outcomes of the event and lock a
small risk-free profit, known as a Dutch book. This profit would typically be
between 1% and 5% but can be much higher. One problem with sports
arbitrage is that bookmakers sometimes make mistakes and this can lead to an
invocation of the 'palpable error' rule, which most bookmakers invoke when
they have made a mistake by offering or posting incorrect odds. As bookmakers
become more proficient, the odds of making an 'arb' usually last for less than
an hour and typically only a few minutes. Furthermore, huge bets on one side
of the market also alert the bookies to correct the market.
• Exchange-traded fund arbitrage – Exchange Traded Funds allow authorized
participants to exchange back and forth between shares in underlying
securities held by the fund and shares in the fund itself, rather than allowing
the buying and selling of shares in the ETF directly with the fund sponsor. ETFs
trade in the open market, with prices set by market demand. An ETF may trade
 at a premium or discount to the value of the underlying assets. When a
significant enough premium appears, an arbitrageur will buy the underlying
securities, convert them to shares in the ETF, and sell them in the open market.
When a discount appears, an arbitrageur will do the reverse. In this way, the
arbitrageur makes a low-risk profit, while fulfilling a useful function in the ETF
marketplace by keeping ETF prices in line with their underlying value.
• Some types of hedge funds make use of a modified form of arbitrage to
profit. Rather than exploiting price differences between identical assets, they
will purchase and sellsecurities, assets and derivatives with similar
characteristics, and hedge any significant differences between the two assets.
Any difference between the hedged positions represents any remaining risk
(such as basis risk) plus profit; the belief is that there remains some difference
which, even after hedging most risk, represents pure profit. For example, a fund
may see that there is a substantial difference between U.S. dollar debt and
local currency debt of a foreign country, and enter into a series of matching
trades (including currency swaps) to arbitrage the difference, while
simultaneously entering into credit default swaps to protect against country
risk and other types of specific risk.
[edit] Price convergence
Arbitrage has the effect of causing prices in different markets to converge. As a
result of arbitrage, the currency exchange rates, the price of commodities, and
the price of securities in different markets tend to converge to the same prices, in
all markets, in each category. The speed at which prices converge is a measure of
market efficiency. Arbitrage tends to reduceprice discrimination by encouraging
people to buy an item where the price is low and resell it where the price is high,
as long as the buyers are not prohibited from reselling and the transaction costs
of buying, holding and reselling are small relative to the difference in prices in the
different markets.

Arbitrage moves different currencies toward purchasing power parity. As an

example, assume that a car purchased in the United States is cheaper than the
same car in Canada. Canadians would buy their cars across the border to exploit
the arbitrage condition. At the same time, Americans would buy US cars,
transport them across the border, and sell them in Canada. Canadians would have
to buy American Dollars to buy the cars, and Americans would have to sell the
Canadian dollars they received in exchange for the exported cars. Both actions
would increase demand for US Dollars, and supply of Canadian Dollars, and as a
result, there would be an appreciation of the US Dollar. Eventually, if unchecked,
this would make US cars more expensive for all buyers, and Canadian cars
cheaper, until there is no longer an incentive to buy cars in the US and sell them
in Canada. More generally, international arbitrage opportunities in commodities,
goods, securities and currencies, on a grand scale, tend to change exchange
rates until the purchasing power is equal.

In reality, of course, one must consider taxes and the costs of travelling back and
forth between the US and Canada. Also, the features built into the cars sold in the
US are not exactly the same as the features built into the cars for sale in Canada,
due, among other things, to the different emissions and other auto regulations in
the two countries. In addition, our example assumes that no duties have to be
paid on importing or exporting cars from the USA to Canada. Similarly,
most assets exhibit (small) differences between countries, transaction costs,
taxes, and other costs provide an impediment to this kind of arbitrage.
Similarly, arbitrage affects the difference in interest rates paid on government
bonds, issued by the various countries, given the expected depreciations in the
currencies, relative to each other (see interest rate parity).

[edit] Risks
Arbitrage transactions in modern securities markets involve fairly low day-to-day
risks, but can face extremely high risk in rare situations, particularly financial
crises, and can lead tobankruptcy. Formally, arbitrage transactions have negative
skew – prices can get a small amount closer (but often no closer than 0), while
they can get very far apart. The day-to-day risks are generally small because the
transactions involve small differences in price, so an execution failure will
generally cause a small loss (unless the trade is very big or the price moves
rapidly). The rare case risks are extremely high because these small price
differences are converted to large profits via leverage (borrowed money), and in
the rare event of a large price move, this may yield a large loss.

The main day-to-day risk is that part of the transaction fails – execution risk. The
main rare risks are counterparty risk and liquidity risk – that a counterparty to a
large transaction or many transactions fails to pay, or that one is required to
post margin and does not have the money to do so.

In the academic literature, the idea that seemingly very low risk arbitrage trades
might not be fully exploited because of these risk factors and other considerations
is often referred to aslimits to arbitrage.[1]

[edit] Execution risk

Generally it is impossible to close two or three transactions at the same instant;
therefore, there is the possibility that when one part of the deal is closed, a quick
shift in prices makes it impossible to close the other at a profitable price.

Competition in the marketplace can also create risks during arbitrage

transactions. As an example, if one was trying to profit from a price discrepancy
between IBM on the NYSE and IBM on the London Stock Exchange, they may
purchase a large number of shares on the NYSE and find that they cannot
simultaneously sell on the LSE. This leaves the arbitrageur in an unhedged risk
position.

In the 1980s, risk arbitrage was common. In this form of speculation, one trades a
security that is clearly undervalued or overvalued, when it is seen that the wrong
valuation is about to be corrected by events. The standard example is the stock of
a company, undervalued in the stock market, which is about to be the object of a
takeover bid; the price of the takeover will more truly reflect the value of the
company, giving a large profit to those who bought at the current price—if the
merger goes through as predicted. Traditionally, arbitrage transactions in the
securities markets involve high speed and low risk. At some moment a price
difference exists, and the problem is to execute two or three balancing
transactions while the difference persists (that is, before the other arbitrageurs
act). When the transaction involves a delay of weeks or months, as above, it may
entail considerable risk if borrowed money is used to magnify the reward through
leverage. One way of reducing the risk is through the illegal use of inside
information, and in fact risk arbitrage with regard to leveraged buyoutswas
associated with some of the famous financial scandals of the 1980s such as those
involving Michael Milken and Ivan Boesky.

[edit] Mismatch
For more details on this topic, see Convergence trade.
Another risk occurs if the items being bought and sold are not identical and the
arbitrage is conducted under the assumption that the prices of the items are
correlated or predictable; this is more narrowly referred to as a convergence
trade. In the extreme case this is risk arbitrage, described below. In comparison to
the classical quick arbitrage transaction, such an operation can produce
disastrous losses.

[edit] Counterparty risk

As arbitrages generally involve future movements of cash, they are subject
to counterparty risk: if a counterparty fails to fulfill their side of a transaction. This
is a serious problem if one has either a single trade or many related trades with a
single counterparty, whose failure thus poses a threat, or in the event of a
financial crisis when many counterparties fail. This hazard is serious because of
the large quantities one must trade in order to make a profit on small price
differences.

For example, if one purchases many risky bonds, then hedges them with CDSes,
profiting from the difference between the bond spread and the CDS premium, in a
financial crisis the bonds may default and the CDS writer/seller may itself fail, due
to the stress of the crisis, causing the arbitrageur to face steep losses.

[edit] Liquidity risk

The market can stay irrational longer than

“ you can stay solvent.

”
—John Maynard Keynes

Arbitrage trades are necessarily synthetic, leveraged trades, as they involve a

short position. If the assets used are not identical (so a price divergence makes
the trade temporarily lose money), or the margin treatment is not identical, and
the trader is accordingly required to post margin (faces a margin call), the trader
may run out of capital (if they run out of cash and cannot borrow more) and go
bankrupt even though the trades may be expected to ultimately make money. In
effect, arbitrage traders synthesize a put option on their ability to finance
themselves.[2]

Prices may diverge during a financial crisis, often termed a "flight to quality";
these are precisely the times when it is hardest for leveraged investors to raise
capital (due to overall capital constraints), and thus they will lack capital precisely
when they need it most.[2]

[edit] Types of arbitrage

[edit] Merger arbitrage
Also called risk arbitrage, merger arbitrage generally consists of buying the stock
of a company that is the target of a takeover while shorting the stock of the
acquiring company.

Usually the market price of the target company is less than the price offered by
the acquiring company. The spread between these two prices depends mainly on
the probability and the timing of the takeover being completed as well as the
prevailing level of interest rates.

The bet in a merger arbitrage is that such a spread will eventually be zero, if and
when the takeover is completed. The risk is that the deal "breaks" and the spread
massively widens.

[edit] Municipal bond arbitrage

Also called municipal bond relative value arbitrage, municipal arbitrage, or
just muni arb, this hedge fund strategy involves one of two approaches.

Generally, managers seek relative value opportunities by being both long and
short municipal bonds with a duration-neutral book. The relative value trades may
be between different issuers, different bonds issued by the same entity, or capital
structure trades referencing the same asset (in the case of revenue bonds).
Managers aim to capture the inefficiencies arising from the heavy participation of
non-economic investors (i.e., high income "buy and hold" investors seeking tax-
exempt income) as well as the "crossover buying" arising from corporations' or
individuals' changing income tax situations (i.e., insurers switching their munis for
corporates after a large loss as they can capture a higher after-tax yield by
offsetting the taxable corporate income with underwriting losses). There are
additional inefficiencies arising from the highly fragmented nature of the
municipal bond market which has two million outstanding issues and 50,000
issuers in contrast to the Treasury market which has 400 issues and a single
issuer.

Second, managers construct leveraged portfolios of AAA- or AA-rated tax-exempt

municipal bonds with the duration risk hedged by shorting the appropriate ratio of
taxable corporate bonds. These corporate equivalents are typically interest rate
swaps referencing Libor or SIFMA[2] [3]. The arbitrage manifests itself in the form
of a relatively cheap longer maturity municipal bond, which is a municipal bond
that yields significantly more than 65% of a corresponding taxable corporate
bond. The steeper slope of the municipal yield curve allows participants to collect
more after-tax income from the municipal bond portfolio than is spent on the
interest rate swap; the carry is greater than the hedge expense. Positive, tax-free
carry from muni arb can reach into the double digits. The bet in this municipal
bond arbitrage is that, over a longer period of time, two similar instruments—
municipal bonds and interest rate swaps—will correlate with each other; they are
both very high quality credits, have the same maturity and are denominated in
U.S. dollars. Credit risk and duration risk are largely eliminated in this strategy.
However, basis risk arises from use of an imperfect hedge, which results in
significant, but range-bound principal volatility. The end goal is to limit this
principal volatility, eliminating its relevance over time as the high, consistent, tax-
free cash flow accumulates. Since the inefficiency is related to government tax
policy, and hence is structural in nature, it has not been arbitraged away.
[edit] Convertible bond arbitrage
A convertible bond is a bond that an investor can return to the issuing company in
exchange for a predetermined number of shares in the company.

A convertible bond can be thought of as a corporate bond with a stock call

option attached to it.

The price of a convertible bond is sensitive to three major factors:

• interest rate. When rates move higher, the bond part of a convertible bond
tends to move lower, but the call option part of a convertible bond moves
higher (and the aggregate tends to move lower).
• stock price. When the price of the stock the bond is convertible into moves
higher, the price of the bond tends to rise.
• credit spread. If the creditworthiness of the issuer deteriorates
(e.g. rating downgrade) and its credit spread widens, the bond price tends to
move lower, but, in many cases, the call option part of the convertible bond
moves higher (since credit spread correlates with volatility).
Given the complexity of the calculations involved and the convoluted structure
that a convertible bond can have, an arbitrageur often relies on sophisticated
quantitative models in order to identify bonds that are trading cheap versus their
theoretical value.

Convertible arbitrage consists of buying a convertible bond and hedging two of

the three factors in order to gain exposure to the third factor at a very attractive
price.

For instance an arbitrageur would first buy a convertible bond, then sell fixed
income securities or interest rate futures (to hedge the interest rate exposure)
and buy some credit protection (to hedge the risk of credit deterioration).
Eventually what he'd be left with is something similar to a call option on the
underlying stock, acquired at a very low price. He could then make money either
selling some of the more expensive options that are openly traded in the market
or delta hedging his exposure to the underlying shares.

[edit] Depository receipts

A depository receipt is a security that is offered as a "tracking stock" on another
foreign market. For instance a Chinese company wishing to raise more money
may issue a depository receipt on the New York Stock Exchange, as the amount of
capital on the local exchanges is limited. These securities, known as ADRs
(American Depositary Receipt) or GDRs (Global Depositary Receipt) depending on
where they are issued, are typically considered "foreign" and therefore trade at a
lower value when first released. However, they are exchangeable into the original
security (known as fungibility) and actually have the same value. In this case
there is a spread between the perceived value and real value, which can be
extracted. Since the ADR is trading at a value lower than what it is worth, one can
purchase the ADR and expect to make money as its value converges on the
original. However there is a chance that the original stock will fall in value too, so
by shorting it you can hedge that risk.

[edit] Dual-listed companies

A dual-listed company (DLC) structure involves two companies incorporated in
different countries contractually agreeing to operate their businesses as if they
were a single enterprise, while retaining their separate legal identity and existing
stock exchange listings. In integrated and efficient financial markets, stock prices
of the twin pair should move in lockstep. In practice, DLC share prices exhibit
large deviations from theoretical parity. Arbitrage positions in DLCs can be set-up
by obtaining a long position in the relatively underpriced part of the DLC and a
short position in the relatively overpriced part. Such arbitrage strategies start
paying off as soon as the relative prices of the two DLC stocks converge toward
theoretical parity. However, since there is no identifiable date at which DLC prices
will converge, arbitrage positions sometimes have to be kept open for
considerable periods of time. In the meantime, the price gap might widen. In
these situations, arbitrageurs may receive margin calls, after which they would
most likely be forced to liquidate part of the position at a highly unfavorable
moment and suffer a loss. Arbitrage in DLCs may be profitable, but is also very
risky, see [3]. Background material is available at [4].

A good illustration of the risk of DLC arbitrage is the position in Royal Dutch Shell
—which had a DLC structure until 2005—by the hedge fund Long-Term Capital
Management (LTCM, see also the discussion below). Lowenstein
(2000) [4] describes that LTCM established an arbitrage position in Royal Dutch
Shell in the summer of 1997, when Royal Dutch traded at an 8 to 10 percent
premium. In total $2.3 billion was invested, half of which long in Shell and the
other half short in Royal Dutch (Lowenstein, p. 99). In the autumn of 1998 large
defaults on Russian debt created significant losses for the hedge fund and LTCM
had to unwind several positions. Lowenstein reports that the premium of Royal
Dutch had increased to about 22 percent and LTCM had to close the position and
incur a loss. According to Lowenstein (p. 234), LTCM lost $286 million in equity
pairs trading and more than half of this loss is accounted for by the Royal Dutch
Shell trade.

[edit] Private to public equities

The market prices for privately held companies are typically viewed from a return
on investment perspective (such as 25%), whilst publicly held and or exchange
listed companies trade on a Price to Earnings multiple (such as a P/E of 10, which
equates to a 10% ROI). Thus, if a publicly traded company specialises in the
acquisition of privately held companies, from a per-share perspective there is a
gain with every acquisition that falls within these guidelines. Exempli
gratia, Berkshire-Hathaway. A hedge fund that is an example of this type of
arbitrage is Greenridge Capital, which acts as an angel investor retaining equity in
private companies which are in the process of becoming publicly traded, buying in
the private market and later selling in the public market. Private to public equities
arbitrage is a term which can arguably be applied to investment banking in
general. Private markets to public markets differences may also help explain the
overnight windfall gains enjoyed by principals of companies that just did an initial
public offering.

[edit] Regulatory arbitrage

For more details on this topic, see Jurisdictional arbitrage.
Regulatory arbitrage is where a regulated institution takes advantage of the
difference between its real (or economic) risk and the regulatory position. For
example, if a bank, operating under the Basel I accord, has to hold 8% capital
against default risk, but the real risk of default is lower, it is profitable
to securitise the loan, removing the low risk loan from its portfolio. On the other
hand, if the real risk is higher than the regulatory risk then it is profitable to make
that loan and hold on to it, provided it is priced appropriately.

This process can increase the overall riskiness of institutions under a risk
insensitive regulatory regime, as described by Alan Greenspan in his October
1998 speech on The Role of Capital in Optimal Banking Supervision and
Regulation.

Regulatory Arbitrage was used for the first time in 2005 when it was applied by
Scott V. Simpson, a partner at law firm Skadden, Arps, to refer to a new defence
tactic in hostile mergers and acquisitions where differing takeover regimes in
deals involving multi-jurisdictions are exploited to the advantage of a target
company under threat.

In economics, regulatory arbitrage (sometimes, tax arbitrage) may be used to

refer to situations when a company can choose a nominal place of business with a
regulatory, legal or tax regime with lower costs. For example,
an insurance company may choose to locate in Bermuda due to preferential tax
rates and policies for insurance companies. This can occur particularly where the
business transaction has no obvious physical location: in the case of many
financial products, it may be unclear "where" the transaction occurs.

Regulatory arbitrage can include restructuring a bank by outsourcing services

such as IT. The outsourcing company takes over the installations, buying out the
bank's assets and charges a periodic service fee back to the bank. This frees up
cashflow usable for new lending by the bank. The bank will have higher IT costs,
but counts on the multiplier effect of money creation and the interest rate spread
to make it a profitable exercise.

Example: Suppose the bank sells its IT installations for 40 million USD. With a
reserve ratio of 10%, the bank can create 400 million USD in additional loans
(there is a time lag, and the bank has to expect to recover the loaned money back
into its books). The bank can often lend (and securitize the loan) to the IT services
company to cover the acquisition cost of the IT installations. This can be at
preferential rates, as the sole client using the IT installation is the bank. If the
bank can generate 5% interest margin on the 400 million of new loans, the bank
will increase interest revenues by 20 million. The IT services company is free to
leverage their balance sheet as aggressively as they and their banker agree to.
This is the reason behind the trend towards outsourcing in the financial sector.
Without this money creation benefit, it is actually more expensive to outsource
the IT operations as the outsourcing adds a layer of management and increases
overhead.

[edit] Telecom arbitrage

Main article: International telecommunications routes
Telecom arbitrage companies allow phone users to make international calls for
free through certain access numbers. Such services are offered in the United
Kingdom; the telecommunication arbitrage companies get paid an interconnect
charge by the UK mobile networks and then buy international routes at a lower
cost. The calls are seen as free by the UK contract mobile phone customers since
they are using up their allocated monthly minutes rather than paying for
additional calls.

Such services were previously offered in the United States by companies such as
FuturePhone.com.[5] These services would operate in rural telephone exchanges,
primarily in small towns in the state of Iowa. In these areas, the local telephone
carriers are allowed to charge a high "termination fee" to the caller's carrier in
order to fund the cost of providing service to the small and sparsely-populated
areas that they serve. However, FuturePhone (as well as other similar services)
ceased operations upon legal challenges from AT&T and other service providers.[6]

[edit] Statistical arbitrage

Main article: Statistical arbitrage
Statistical arbitrage is an imbalance in expected nominal values. A casino has a
statistical arbitrage in every game of chance that it offers—referred to as
the house advantage, house edge, vigorish or house vigorish.

[edit] The debacle of Long-Term Capital

Management
Main article: Long-Term Capital Management
Long-Term Capital Management (LTCM) lost 4.6 billion U.S. dollars in fixed income
arbitrage in September 1998. LTCM had attempted to make money on the price
difference between different bonds. For example, it would sell U.S. Treasury
securities and buy Italian bond futures. The concept was that because Italian bond
futures had a less liquid market, in the short term Italian bond futures would have
a higher return than U.S. bonds, but in the long term, the prices would converge.
Because the difference was small, a large amount of money had to be borrowed
to make the buying and selling profitable.

The downfall in this system began on August 17, 1998, when Russia defaulted on
its ruble debt and domestic dollar debt. Because the markets were already
nervous due to the Asian financial crisis, investors began selling non-U.S. treasury
debt and buying U.S. treasuries, which were considered a safe investment. As a
result the price on US treasuries began to increase and the return began
decreasing because there were many buyers, and the return on other bonds
began to increase because there were many sellers. This caused the difference
between the prices of U.S. treasuries and other bonds to increase, rather than to
decrease as LTCM was expecting. Eventually this caused LTCM to fold, and their
creditors had to arrange a bail-out. More controversially, officials of the Federal
Reserve assisted in the negotiations that led to this bail-out, on the grounds that
so many companies and deals were intertwined with LTCM that if LTCM actually
failed, they would as well, causing a collapse in confidence in the economic
system. Thus LTCM failed as a fixed income arbitrage fund, although it is unclear
what sort of profit was realized by the banks that bailed LTCM out.

[edit] Etymology
Look up arbitrage in Wiktionary, the free dictionary.
"Arbitrage" is a French word and denotes a decision by an arbitrator or arbitration
tribunal. (In modern French, "arbitre" usually means referee or umpire.) In the
sense used here it is first defined in 1704 by Mathieu de la Porte in his treatise "La
science des négocians et teneurs de livres" as a consideration of different
exchange rates to recognize the most profitable places of issuance and
settlement for a bill of exchange ("L'arbitrage est une combinaison que l’on fait de
plusieurs changes, pour connoitre [connaître, in modern spelling] quelle place est
plus avantageuse pour tirer et remettre".)[7]

[edit] See also

[edit] Types of financial arbitrage
• Arbitrage betting
• Covered interest arbitrage
• Fixed income arbitrage
• Political arbitrage
• Risk arbitrage
• Statistical arbitrage
• Triangular arbitrage
• Uncovered interest arbitrage
• Volatility arbitrage
[edit] Related concepts
• Algorithmic trading
• Arbitrage pricing theory
• Coherence (philosophical gambling strategy), analogous concept
in Bayesian probability
• Efficient market hypothesis
• Immunization (finance)
• Interest rate parity
• Intermediation
• TANSTAAFL
• Value investing
[edit] Notes
1. ^ As an arbitrage consists of at least two trades, the metaphor is of
putting on a pair of pants, one leg (trade) at a time. The risk that one trade
(leg) fails to execute is thus 'leg risk'.
[edit] References
1. ^ See e.g. Shleifer, Andrei, and Robert Vishny, 1997, The limits of
arbitrage, Journal of Finance 52, 35-55.
Xiong, Wei, 2001, Convergence trading with wealth effects, Journal of
Financial Economics 62, 247-292.
Kondor, Peter, 2009. Risk in Dynamic Arbitrage: Price Effects of
Convergence Trading Journal of Finance 64(2),638-658,
2. ^ a b The Basis Monster That Ate Wall Street, D. E. Shaw & Co.
3. ^ de Jong, A., L. Rosenthal and M.A. van Dijk, 2008, The Risk and Return of
Arbitrage in Dual-Listed Companies, June 2008.[1]
4. ^ Lowenstein, R., 2000, When genius failed: The rise and fall of Long-Term
Capital Management, Random House.
 5. ^ Ned Potter (2006-10-13). "Free International Calls! Just Dial ...
Iowa". http://abcnews.go.com/Technology/story?id=2560255. Retrieved
2008-12-23.
6. ^ Mike Masnick (2007-02-07). "Phone Call Arbitrage Is All Fun And Games
(And Profit) Until AT&T Hits You With A $2 Million
Lawsuit".http://techdirt.com/articles/20070207/123022.shtml. Retrieved
2008-12-23.
7. ^ See "Arbitrage" in Trésor de la Langue Française.
• Greider, William (1997). One World, Ready or Not. Penguin Press. ISBN 0-
7139-9211-5.
• Special Situation Investing: Hedging, Arbitrage, and Liquidation, Brian J.
Stark, Dow-Jones Publishers. New York, NY 1983. ISBN 0870943847; ISBN
9780870943843
[edit] External links
• What is Arbitrage? (About.com)
• ArbitrageView.com – Arbitrage opportunities in pending merger deals in
the U.S. market
• Information on arbitrage in dual-listed companies on the website of Mathijs
A. van Dijk.
• What is Regulatory Arbitrage. Regulatory Arbitrage after the Basel ii
framework and the 8th Company Law Directive of the European Union.
Retrieved from "http://en.wikipedia.org/wiki/Arbitrage"
Categories: Financial markets
Hidden categories: Articles containing French language text
Personal tools
• New features
• Log in / create account
Namespaces
• Article
• Discussion
Variants
Views
• Read
• Edit
• View history
Actions
Search

Navigation
• Main page
• Contents
• Featured content
• Current events
• Random article
• Donate
Interaction
 • About Wikipedia
• Community portal
• Recent changes
• Contact Wikipedia
• Help
Toolbox
• What links here
• Related changes
• Upload file
• Special pages
• Permanent link
• Cite this page
Print/export
• Create a book
• Download as PDF
• Printable version
Languages
• ‫العربية‬
• Česky
• Deutsch
• Eesti
• Ελληνικά
• Español
• ‫فارسی‬
• Français
• िहनदी
• Bahasa Indonesia
• Íslenska
• Italiano
• ‫עברית‬
• Nederlands
• 日本語
• Norsk (bokmål)
• Polski
• Português
• Русский
• Suomi
• Svenska
• Türkçe
• 中文
• This page was last modified on 9 September 2010 at 22:29.
• Text is available under the Creative Commons Attribution-ShareAlike
License; additional terms may apply. See Terms of Use for details.
Wikipedia® is a registered trademark of the Wikimedia Foundation, Inc., a non-
profit organization.
• Contact us
• Privacy policy
 • About Wikipedia
• Disclaimers

•
This E-mail is confidential. It may also be legally privileged. If you are not the
addressee you may not copy, forward, disclose or use any part of it. If you have
received this message in error, please delete it and all copies from your system
and notify the sender immediately by return E-mail. Internet communications
cannot be guaranteed to be timely, secure, error or virus-free. MCB Bank does not
accept liability for any errors or omissions.

--Forwarded Message Attachment--

From:
Subject: Foreign Exchange Market
Date: Fri, 24 Sep 2010 16:35:09 +0500

Foreign Exchange Market

1. CHARACTERISTICS OF FE
MARKET
Barter exchange (Double
coincidence of wants): In the
foreign exchange market, for
anybody wanting to sell
dollars to get British pound,
Barter Exchange
there must be someone else
wanting to sell the pound for
the dollar at the same
exchange rate (like in barter
exchange).

Role The FE market performs an

international clearing
function by bringing two
parties wishing to trade
currencies at agreeable
exchange rates.

The FE market takes place

between dealers and brokers
in financial centers around
the world. During the hours
of business common to
different time zones, they
rapidly exchange shorthand
messages expressing their
bids for different currencies.

To make a profit on FE
maneuvers, a trader or
broker has to make quick
decisions correctly. Foreign
exchange traders lead an
exciting and hectic life, and
the pressure often shortens
many careers.

The fastest possible

communications are used.
Before the trans-Atlantic
cable was laid in 1865 by
Cyrus West Field (after
many failed attempts),
somebody wanting to
exchange dollars for pounds
often had to wait the time
required for a roundtrip
voyage to clear up the
 transaction. Modern
telephone links have reduced
the transaction costs on
foreign exchange to near
zero for large transactions.

Currencies of the world

2. Origin of Money

Inside the lid, there is a Chinese

character written below. Cowries were
used as money during the Shang dynasty
(1600 - 1046 BC)
3. The advantages of the Foreign Exchange
Market
Volume The daily volume of business dealt
with on the foreign exchange markets
in 1998 was estimated to be over $2.5
trillion dollars.

(Daily volume on New York Stock

Exchanges is about $20 billion)
Today (2006) it may be about $5
trillion dollars. The daily volume of
the foreign exchange market in North
America in October 2005 was about
 $440 billion.

The Foreign Exchange market

expanded considerably since
President Nixon closed the gold
window and currencies were left
afloat vis-á-vis other currencies and
speculators could profit from their
transactions.

Until recently, this market was used

mostly by banks, who fully
appreciated the excellent
Who opportunities to increase their profits.
Today, it is accessible to any investor
enabling him to diversify his
portfolio.

traded (i) dollar is still the dominant

Currencies currency.
(ii) The emergence of Yen as a major
currency, and

(iii) new Euro, in addition to the

Dollar beside many other currencies,
and the frequent fluctuations in
relative value of these currencies
provide a great opportunity to
generate substantial profits.

(iv) RMB: Chinese Renminbi is

convertible on current account, but
 not on capital account. When it
becomes fully convertible, which is
not likely to occur until 2020 or later,
it will fundamentally affect the
foreign exchange market due to its
sheer volume.

The foreign exchange market

operates 24 hours a day permitting
When intervention in the major
international foreign exchange
markets at any point in time.

4. Some FE Customs
Although there is an exchange rate
between the domestic currency and
every other currency, most FE
transactions involve only a small
traded number of international currencies.
currencies Average daily transactions in 1998
was over $2.5 trillion. $637B
(London), $351B (New York),
$149B (Tokyo).

Euro
Before the single currency euro was
launched in 2002, the composition of
foreign currency transactions in the
New York market in 1985 was as
 follows: Mark 32%, Pound 23%,
Canada $ 12%, Yen 10%, Swiss
Franc 10%, others 13%.

The introduction of euro in 2002

dramatically changed the
composition of these foreign
currencies as most of European
currencies were no longer circulated.
The foreign exchange markets were
handling over $450 billion per day
through New York, London and
Frankfurt. (most market economies
have less GNP). Today it is
estimated to be more than $5T a day.

Selling The exchange rate is the domestic

price price of a foreign currency. The FE
quotations list selling price in dollars
or foreign currency per dollar.
The selling price refers to the price
at which a large customer could have
bought the currency from the
dealers. The buying price at which
one could have sold foreign currency
to the dealers is normally 0.1%
below the selling price, which
represents the commission of FE
dealers or banks. This is called
interbank trading as it occurs usually
between foreign exchange dealers in
different banks in major financial
 centers. Obviously, the "retail" rates
for corporate customers are less
favorable than the "wholesale" rates.

This spread can be higher in foreign

exchange markets other than New
York/London, and also in exchange
crisis, and in rarely traded
Spread
currencies. Because the market
participants know this customary
spread, usually selling prices are
published.

Spot rates (i) For most currencies, only a spot

rate is quoted. Spot exchange is
foreign exchange for immediate
delivery that is used for international
payments (for imports and
investment). The daily quotations are
for bank (cable) transfers. While
transactions between these banks are
instantaneous, these funds become
available for use by customers 1-2
working days after the purchase.
(ii) Transactions agreed on Monday
will result in payments on
Wednesday. Those agreed on
Thursday will be available on
Monday. Canadian/US dollar
business is cleared in one day
(because Toronto and New York are
 in the same time zone).

(iii) Some New York banks maintain

2 shifts (one arriving at office at 3
am when London and Frankfurt are
open). Large New York banks also
have branches in Tokyo, Frankfurt,
and London. Thus, they are in
contact with all financial centers 24
hours.

(iv) When a FE dealer or broker

quotes a price on the telephone, he
can be held to it for only a few
seconds (It used to be up to 1
minute). Dealers may quote different
prices to different customers. Prices
change throughout the day.
Bluffing/counterbluffing for a large
sum of FE. For average customers, it
does not pay to get more than one
quote.

Buying and selling rates for bank

notes may be listed. Prices do not
change throughout the day. Selling
Bank price for BN may be higher/lower
notes than the selling price for Cable
transfers. The spread is much larger
than 0.1% for cable transfers, and
may go up to 5-10%.
 forward rates are for currency to be
delivered 30, 90 or 180 days later at
Forward the known price on a given day.
rates Forward rates are available for major
international currencies.

Currency futures markets were

established by Chicago Mercantille
exchange in 1972. Futures prices are
Currency for contracts applicable to a specific
futures calendar dates (Third Wednesday of
June, September, December and
March).

5. Participants of the Foreign Exchange

markets
Retail They are importers/exporters of
customers goods, services and financial assets
(stocks/bonds).

They are most numerous.

They buy and sell FE for transaction

purposes.

These do not usually trade

currencies one another because it is
difficult to match double
coincidence of wants. Instead they
 go to a commercial bank for the
transactions.

Foreign (i) FE Dealers are large

Exchange commercial banks, which buy and
dealers sell FE. Specifically, they are the
international departments of large
commercial banks in the financial
centers of the world: London, New
York, Tokyo, zurich, Frankfurt,
Paris, Singapore, Hong Kong,
Toronto.

In New York City, there are about

100 such banks.

(ii) Large banks outside the center

also participate through their
affiliates.

(iii) Small regional banks do not

directly participate in the FE
market. But to meet their customers'
FE need, they deal with
correspondant banks. Almost
14,000 commercial banks maintain
corresponent relationship with FE
dealers.

(iv) FE dealers typically maintain a

trading room equipped with
telephones and telex machines.
 They ususally communicate directly
with the trading rooms of banks in
other centers. They go through a
broker when dealing with other
banks in the same center. They are
exposed to FE risks.

These are wholesale dealers

between FE dealers. FE dealers may
develop shortage/surplus. Then they
go to brokers.Brokers do not take
open positions in the FE market.
FE brokers
There are 8 brokers in New York,
and less than 100 in the U.S. They
usually specialize in a few
currencies, and earn commission =
1/10 of 1% - 1/8 of 1%.

Central participate (i) to facilitate

Banks Treasury's transactions, and (ii) to
prevent or effect a change in the
value of their currency.

(i) in the US, Federal Reserve Bank

of NY acts as agent for the entire
Federal Reserve System and the
Treasury Department.

(ii) it usually try to conceal its

intervention. It may requres an
obscure bank in Midwest to place
 an order in the New York market.

(iii) Sometimes it tries to publicize

its buying intent.

numerous, but they participate

Speculators
through FE dealers.

5. Three Traders
Videotape World Poker Championship: Cards
(June 4, are shown only to the viewers.
1985) Apparently, viewers cannot convey
any message to the players. The
winner's prize is over $2 million.
With sharp minds, the players can
incorporate all the information on
the displayed cards and calculate
the probability of a desired card. In
the case of poker, there are only 52
possible cards. Accordingly, bright
individuals can compute the
probabilities of winning of his own
and competing players. These
probabilities of winning are almost
instantaneously computed for TV
viewers.

Since so many things can possibly

affect the probability that a
currency will rise against another,
 computer programs or formulas for
the price of a given stock or
currency to rise cannot be devised.
Some investment companies will
claim they have developed a certain
formula or program to buy and sell
currencies (or stocks), but they are
doomed. If a particular method
brings profits to the investor, more
people will invest money into that
formula, thereby driving the prices
of currencies/stocks downward and
raising the prices of those they are
selling, eventually eliminating
profits.

Instead of relying on a fixed

formula, currency dealers can
incorporate all the available
information about the currency
markets and other news on world
events which affect the currency
values.

Ronnie Swiss, lives in New York

Schlaefer long term speculator (he holds
foreign currencies even over night)
(speculator) has a bunch of medical doctors who
invests a minimum of $0.5 million.
13 rich investors, around the world
50% profit rate in 1984.
 management fee = fixed.
performance fee = 20- 25% once a
year.
made many mistakes of missing the
moment to sell mark, but breaks
even at the end of the day

Richard 31 years old, works for London

Hill Barclay. gets No commission.
The majority of traders are 20 - 35
years old.
Chris Pablo: boss. A sterling dealer,
old. Traders must concentrate when
working. People get nervous.
Traders earn fixed salary. No
commission, but pushed aside if
when a big mistake is made.
Hill finds out that Russians
(Moscow) are buying £ with mark,
jumps on the bandwagon by buying
£, thereby raising the price a little
and then sells it later.

Hill bought and sold 750 million £

and profited π = $160,000
(£91,400) that day. (one day's
interest at 1% is £20547). The rate
of return is about 8% per year.

U: = you, pls = please

 Barclay: 8 dealers, made $150
million profit, 1984
($.5 million a day) Today, their
profits from foreign exchange
transactions would be over $1
million a day.

(works for Chemical bank, Hong

Kong) sold £20 million, made
($20,000 morning) pounds he
bought worth $30,000 less (from
Richard Hill).
Salary = $40,000 + 3%
commission.

When selling a large amount of FE,

William people notice it and price falls. To
Wong avoid it, William Wong requests
the assistance of other dealers and
sell £ simultaneously.

At the end of the day, he bought

and sold 120 million £, with profit
= $30,000 (£17,142), which is
equivalent to one day's interest on
the principal at 5.2 % per year.

6. Exchange Arbitrage
Definition Exchange arbitrage involes the
 simultaneous purchase and sale of a
currency in different foreign
exchange markets. Thus, arbitragers
take a closed position. (No risk)

Arbitrage becomes profitable

whenever the price of a currency in
one market differs from that in
another market.

Suppose the pound quoted in NY is

$1.75, but pound quoted in London
is $1.78. Then an arbitrager in NY
and his partner in London can take
the following steps:
How
(a) buy 10 M pounds in NY: cost =
$17.5 M

(b) sell 10 M pounds in London:

revenue = $17.8 M

(c) profit = $300,000 less the cost of

telephone, cable transfer.The supply
of pound shrinks in NY, increases in
London.

Effect of wipe out the spread in exchange

arbitrage rates between FE markets.

7. Currency Speculation
 Speculators assume an open
position, i.e., take risk in the FE
Speculation
markets. Their intention is to make
is risky
windfall gains from the fluctuations
in the FE markets.

When to
buy?

Forward Exchange Rate

Forward exchange markets deal in
promises to sell or buy foreign
exchange at a specified rate, and at a
specified time in the future with
payment to be made upon delivery.
These promises are known as
forward exchange and the price is the
forward exchange rate. Forward
Definition exchange markets do not operate
during periods of hyperinflation.
The forward exchange market
resembles the futures markets found
in organized commodity markets,
such as wheat and coffee. The
primary function of forward market
is to afford protection against the risk
of fluctuations in exchange rates.

when Forward markets are most useful

forward (i) under flexible exchange rate
markets are system and if there are significant
 exchange variations,

(ii) under fixed exchange rate

active
system, if there is a strong possibility
of devaluation/revaluation,

(i) it cannot function when exchange

control is imposed.
Non
operational (ii) it cannot function during perids
of hyperinflation.

9. Interest Parity Theory (Keynes)

What is It is John Maynard Keynes' theory of
IPT? how forward rates are determined.

When short term interests are higher

in one market than in another,
investors will be motivated to shift
funds between markets, say New
York and London.

Investors borrow (or buy) a low

interest currency and lend the same
amount in a high interest currency.
This is called carry trade. There is
roughly a 5% difference in the
interest rates between Japan and the
US. To make profits from differeing
interest rates, investors must convert,
for example, dollars (a low interest
currency) into pound sterling (a high
interest currency) for investment in
London. However, they would be
exposed to an exchange risk. If the
exchange rate is stable, the investors
gain the interest differential, (i - i*),
by shifting funds from New York to
London.

If pound appreciates during the

investment period, the foreign
investors will reap additional gain in
the change in the exchange rate.
However, if pound depreciates, they
will experience an exchange loss.
The exchange loss may partially or
more than offset the gain in the
interest income.

To avoid this exchange loss,

dollar investors want cover against
the exchange loss by selling pound
forward. The amount of forward
pound to sell is equal to the purchase
of spot pound plus the interest earned
in London. This practice is
calledinterest arbitrage. Interest
arbitrage links the two national
money markets and the forward
 market.

Assume: a US investor has A dollars

to invest, either in New York or in
London. The annual interests in the
Example US and the UK are 8% and 12%,
respectively. The quarterly interest
rates in the US and UK are then 2%
and 3%, respectively.

Do (1) Invest in New York for 90 days.

nothing $1M(1 + .02) = $1.02M
(take risk)
(2) Invest in London

£t=0 = $1M/spot = $1M/1.5 =

£666,667.

If St=90 = St=0, then investing overseas

is better ($10,000 more return).

If St=90 = 1.65 (£ rose 10%), then

$10,000 (interest gain) + $103,000

(appreciation of £) = $113,000
(foreign investment is definitely
better).

If St=90 = 1.35 (£ fell 10%), then

$10,000 (interest gain) - $103,000

(depreciation of £) = - $93,000.
 Most investors would rather avoid
this exchange risk.

Windows Live™
•
•
•
•
•
•
• Hotmail (0)
• Messenger
• Office
• Photos
Mohsin Hayat
•
•
•
•
•
profile | sign out

Hotmail
• Inbox

Folders

• Junk
• Drafts
• Sent
• Deleted
• New folder
Quick views
• Flagged
• Photos
• Office docs
Messenger

• Sign in to Messenger
• Home
• Contacts
• Calendar
o New
o |
o Reply
o Reply all
o Forward
 o |
o Delete
o Junk
o Sweep ▼



o Mark as ▼






o Move to ▼

o |
o
o
▼
o





o
o Options ▼







•
•
• |
• Back to messages
Fw: Arbitrage and Its types in Forex Markets
9/27/2010
Reply ▼

•
•
•
•
•
•
•
•
•
•
•

Mohsin Hayat
To Mohsin Hayat
From: Mohsin Hayat (mohsin.hayat)
Sent: Monday, September 27, 2010 6:20:28 PM
To: Mohsin Hayat (mohcinhayat@hotmail.com)

This message looks suspicious to our SmartScreen filters.

Hotmail Active View

42 attachments (total 3.4 MB)

Download

Download

Download

search-lt...png283t
Download(0.2 KB)

Download

Download

main-ltr....css283t
 Download(34.8 KB)
View slide show (16)
|
Download all

----- Original Message -----

From: Imtiaz Aslam
To: mohsin.hayat@mcb.com.pk
Cc: imtiazjee143@yahoomail.com
Sent: 24 September, 2010 4:52 PM
Subject: Arbitrage and Its types in Forex Markets

Hy Mohsin ,

Enjoyyyyyyy

Imtiaz.
This E-mail is confidential. It may also be legally privileged. If you are not the
addressee you may not copy, forward, disclose or use any part of it. If you have
received this message in error, please delete it and all copies from your system
and notify the sender immediately by return E-mail. Internet communications
cannot be guaranteed to be timely, secure, error or virus-free. MCB Bank does not
accept liability for any errors or omissions.

--Forwarded Message Attachment--

From:
Subject: Arbitrage - Wikipedia, the free encyclopedia
Date: Fri, 24 Sep 2010 16:20:45 +0500

Arbitrage
From Wikipedia, the free encyclopedia
Jump to: navigation, search
Not to be confused with Arbitration.
In economics and finance, arbitrage (IPA: /ˈɑrbɨtrɑːʒ/) is the practice of taking
advantage of a price difference between two or more markets: striking a
combination of matching deals that capitalize upon the imbalance, the profit
being the difference between the market prices. When used by academics, an
arbitrage is a transaction that involves no negative cash flowat any probabilistic
or temporal state and a positive cash flow in at least one state; in simple terms, it
is the possibility of a risk-free profit at zero cost.

In principle and in academic use, an arbitrage is risk-free; in common use, as

in statistical arbitrage, it may refer to expected profit, though losses may occur,
and in practice, there are always risks in arbitrage, some minor (such as
fluctuation of prices decreasing profit margins), some major (such as devaluation
of a currency or derivative). In academic use, an arbitrage involves taking
advantage of differences in price of a single asset or identical cash-flows; in
common use, it is also used to refer to differences between similar assets (relative
value or convergence trades), as in merger arbitrage.
A person who engages in arbitrage is called an arbitrageur (IPA: /ˌɑrbɨtrɑːˈʒɜr/)—
such as a bank or brokerage firm. The term is mainly applied to trading
in financial instruments, such
asbonds, stocks, derivatives, commodities and currencies.

Contents
• 1 Arbitrage-free
• 2 Conditions for arbitrage
• 3 Examples
• 4 Price convergence
• 5 Risks
• 5.1 Execution risk
• 5.2 Mismatch
• 5.3 Counterparty risk
• 5.4 Liquidity risk
• 6 Types of arbitrage
• 6.1 Merger arbitrage
• 6.2 Municipal bond arbitrage
• 6.3 Convertible bond arbitrage
• 6.4 Depository receipts
• 6.5 Dual-listed companies
• 6.6 Private to public equities
• 6.7 Regulatory arbitrage
• 6.8 Telecom arbitrage
• 6.9 Statistical arbitrage
• 7 The debacle of Long-Term Capital Management
• 8 Etymology
• 9 See also
• 9.1 Types of financial arbitrage
• 9.2 Related concepts
• 10 Notes
• 11 References
• 12 External links
[edit] Arbitrage-free
If the market prices do not allow for profitable arbitrage, the prices are said to
constitute an arbitrage equilibrium or arbitrage-free market. An arbitrage
equilibrium is a precondition for a general economic equilibrium. The assumption
that there is no arbitrage is used in quantitative finance to calculate a unique risk
neutral price for derivatives.

[edit] Conditions for arbitrage

Arbitrage is possible when one of three conditions is met:
 1. The same asset does not trade at the same price on all markets ("the law
of one price").
2. Two assets with identical cash flows do not trade at the same price.
3. An asset with a known price in the future does not today trade at its future
price discounted at the risk-free interest rate (or, the asset does not have
negligible costs of storage; as such, for example, this condition holds for
grain but not for securities).
Arbitrage is not simply the act of buying a product in one market and selling it in
another for a higher price at some later time. The transactions must
occur simultaneously to avoid exposure to market risk, or the risk that prices may
change on one market before both transactions are complete. In practical terms,
this is generally only possible with securities and financial products which can be
traded electronically, and even then, when each leg of the trade is executed the
prices in the market may have moved. Missing one of the legs of the trade (and
subsequently having to trade it soon after at a worse price) is called 'execution
risk' or more specifically 'leg risk'.[note 1]

In the simplest example, any good sold in one market should sell for the same
price in another. Traders may, for example, find that the price of wheat is lower in
agricultural regions than in cities, purchase the good, and transport it to another
region to sell at a higher price. This type of price arbitrage is the most common,
but this simple example ignores the cost of transport, storage, risk, and other
factors. "True" arbitrage requires that there be no market risk involved. Where
securities are traded on more than one exchange, arbitrage occurs by
simultaneously buying in one and selling on the other.

See rational pricing, particularly arbitrage mechanics, for further discussion.

Mathematically it is defined as follows:

and

where Vt means a portfolio at time t.

[edit] Examples
• Suppose that the exchange rates (after taking out the fees for making the
exchange) in London are £5 = $10 = ¥1000 and the exchange rates in Tokyo
are ¥1000 = $12 = £6. Converting ¥1000 to $12 in Tokyo and converting that
$12 into ¥1200 in London, for a profit of ¥200, would be arbitrage. In reality,
this "triangle arbitrage" is so simple that it almost never occurs. But more
complicated foreign exchange arbitrages, such as the spot-forward arbitrage
(see interest rate parity) are much more common.
• One example of arbitrage involves the New York Stock Exchange and
the Chicago Mercantile Exchange. When the price of a stock on the NYSE and
its corresponding futures contract on the CME are out of sync, one can buy the
less expensive one and sell it to the more expensive market. Because the
differences between the prices are likely to be small (and not to last very long),
this can only be done profitably with computers examining a large number of
prices and automatically exercising a trade when the prices are far enough out
of balance. The activity of other arbitrageurs can make this risky. Those with
 the fastest computers and the most expertise take advantage of series of small
differences that would not be profitable if taken individually.
• Economists use the term "global labor arbitrage" to refer to the tendency
of manufacturing jobs to flow towards whichever country has the lowest wages
per unit output at present and has reached the minimum requisite level of
political and economic development to support industrialization. At present,
many such jobs appear to be flowing towards China, though some which
require command of English are going to India and the Philippines. In popular
terms, this is referred to as offshoring. (Note that "offshoring" is not
synonymous with "outsourcing", which means "to subcontract from an outside
supplier or source", such as when a business outsources its bookkeeping to an
accounting firm. Unlike offshoring, outsourcing always involves subcontracting
jobs to a different company, and that company can be in the same country as
the outsourcing company.)
• Sports arbitrage – numerous internet bookmakers offer odds on the
outcome of the same event. Any given bookmaker will weight their odds so that
no one customer can cover all outcomes at a profit against their books.
However, in order to remain competitive their margins are usually quite low.
Different bookmakers may offer different odds on the same outcome of a given
event; by taking the best odds offered by each bookmaker, a customer can
under some circumstances cover all possible outcomes of the event and lock a
small risk-free profit, known as a Dutch book. This profit would typically be
between 1% and 5% but can be much higher. One problem with sports
arbitrage is that bookmakers sometimes make mistakes and this can lead to an
invocation of the 'palpable error' rule, which most bookmakers invoke when
they have made a mistake by offering or posting incorrect odds. As bookmakers
become more proficient, the odds of making an 'arb' usually last for less than
an hour and typically only a few minutes. Furthermore, huge bets on one side
of the market also alert the bookies to correct the market.
• Exchange-traded fund arbitrage – Exchange Traded Funds allow authorized
participants to exchange back and forth between shares in underlying
securities held by the fund and shares in the fund itself, rather than allowing
the buying and selling of shares in the ETF directly with the fund sponsor. ETFs
trade in the open market, with prices set by market demand. An ETF may trade
at a premium or discount to the value of the underlying assets. When a
significant enough premium appears, an arbitrageur will buy the underlying
securities, convert them to shares in the ETF, and sell them in the open market.
When a discount appears, an arbitrageur will do the reverse. In this way, the
arbitrageur makes a low-risk profit, while fulfilling a useful function in the ETF
marketplace by keeping ETF prices in line with their underlying value.
• Some types of hedge funds make use of a modified form of arbitrage to
profit. Rather than exploiting price differences between identical assets, they
will purchase and sellsecurities, assets and derivatives with similar
characteristics, and hedge any significant differences between the two assets.
Any difference between the hedged positions represents any remaining risk
(such as basis risk) plus profit; the belief is that there remains some difference
which, even after hedging most risk, represents pure profit. For example, a fund
may see that there is a substantial difference between U.S. dollar debt and
local currency debt of a foreign country, and enter into a series of matching
trades (including currency swaps) to arbitrage the difference, while
simultaneously entering into credit default swaps to protect against country
risk and other types of specific risk.
[edit] Price convergence
Arbitrage has the effect of causing prices in different markets to converge. As a
result of arbitrage, the currency exchange rates, the price of commodities, and
the price of securities in different markets tend to converge to the same prices, in
all markets, in each category. The speed at which prices converge is a measure of
market efficiency. Arbitrage tends to reduceprice discrimination by encouraging
people to buy an item where the price is low and resell it where the price is high,
as long as the buyers are not prohibited from reselling and the transaction costs
of buying, holding and reselling are small relative to the difference in prices in the
different markets.

Arbitrage moves different currencies toward purchasing power parity. As an

example, assume that a car purchased in the United States is cheaper than the
same car in Canada. Canadians would buy their cars across the border to exploit
the arbitrage condition. At the same time, Americans would buy US cars,
transport them across the border, and sell them in Canada. Canadians would have
to buy American Dollars to buy the cars, and Americans would have to sell the
Canadian dollars they received in exchange for the exported cars. Both actions
would increase demand for US Dollars, and supply of Canadian Dollars, and as a
result, there would be an appreciation of the US Dollar. Eventually, if unchecked,
this would make US cars more expensive for all buyers, and Canadian cars
cheaper, until there is no longer an incentive to buy cars in the US and sell them
in Canada. More generally, international arbitrage opportunities in commodities,
goods, securities and currencies, on a grand scale, tend to change exchange
rates until the purchasing power is equal.

In reality, of course, one must consider taxes and the costs of travelling back and
forth between the US and Canada. Also, the features built into the cars sold in the
US are not exactly the same as the features built into the cars for sale in Canada,
due, among other things, to the different emissions and other auto regulations in
the two countries. In addition, our example assumes that no duties have to be
paid on importing or exporting cars from the USA to Canada. Similarly,
most assets exhibit (small) differences between countries, transaction costs,
taxes, and other costs provide an impediment to this kind of arbitrage.

Similarly, arbitrage affects the difference in interest rates paid on government

bonds, issued by the various countries, given the expected depreciations in the
currencies, relative to each other (see interest rate parity).

[edit] Risks
Arbitrage transactions in modern securities markets involve fairly low day-to-day
risks, but can face extremely high risk in rare situations, particularly financial
crises, and can lead tobankruptcy. Formally, arbitrage transactions have negative
skew – prices can get a small amount closer (but often no closer than 0), while
they can get very far apart. The day-to-day risks are generally small because the
transactions involve small differences in price, so an execution failure will
generally cause a small loss (unless the trade is very big or the price moves
rapidly). The rare case risks are extremely high because these small price
differences are converted to large profits via leverage (borrowed money), and in
the rare event of a large price move, this may yield a large loss.

The main day-to-day risk is that part of the transaction fails – execution risk. The
main rare risks are counterparty risk and liquidity risk – that a counterparty to a
large transaction or many transactions fails to pay, or that one is required to
post margin and does not have the money to do so.

In the academic literature, the idea that seemingly very low risk arbitrage trades
might not be fully exploited because of these risk factors and other considerations
is often referred to aslimits to arbitrage.[1]

[edit] Execution risk

Generally it is impossible to close two or three transactions at the same instant;
therefore, there is the possibility that when one part of the deal is closed, a quick
shift in prices makes it impossible to close the other at a profitable price.

Competition in the marketplace can also create risks during arbitrage

transactions. As an example, if one was trying to profit from a price discrepancy
between IBM on the NYSE and IBM on the London Stock Exchange, they may
purchase a large number of shares on the NYSE and find that they cannot
simultaneously sell on the LSE. This leaves the arbitrageur in an unhedged risk
position.

In the 1980s, risk arbitrage was common. In this form of speculation, one trades a
security that is clearly undervalued or overvalued, when it is seen that the wrong
valuation is about to be corrected by events. The standard example is the stock of
a company, undervalued in the stock market, which is about to be the object of a
takeover bid; the price of the takeover will more truly reflect the value of the
company, giving a large profit to those who bought at the current price—if the
merger goes through as predicted. Traditionally, arbitrage transactions in the
securities markets involve high speed and low risk. At some moment a price
difference exists, and the problem is to execute two or three balancing
transactions while the difference persists (that is, before the other arbitrageurs
act). When the transaction involves a delay of weeks or months, as above, it may
entail considerable risk if borrowed money is used to magnify the reward through
leverage. One way of reducing the risk is through the illegal use of inside
information, and in fact risk arbitrage with regard to leveraged buyoutswas
associated with some of the famous financial scandals of the 1980s such as those
involving Michael Milken and Ivan Boesky.

[edit] Mismatch
For more details on this topic, see Convergence trade.
Another risk occurs if the items being bought and sold are not identical and the
arbitrage is conducted under the assumption that the prices of the items are
correlated or predictable; this is more narrowly referred to as a convergence
trade. In the extreme case this is risk arbitrage, described below. In comparison to
the classical quick arbitrage transaction, such an operation can produce
disastrous losses.

[edit] Counterparty risk

As arbitrages generally involve future movements of cash, they are subject
to counterparty risk: if a counterparty fails to fulfill their side of a transaction. This
is a serious problem if one has either a single trade or many related trades with a
single counterparty, whose failure thus poses a threat, or in the event of a
financial crisis when many counterparties fail. This hazard is serious because of
the large quantities one must trade in order to make a profit on small price
differences.

For example, if one purchases many risky bonds, then hedges them with CDSes,
profiting from the difference between the bond spread and the CDS premium, in a
financial crisis the bonds may default and the CDS writer/seller may itself fail, due
to the stress of the crisis, causing the arbitrageur to face steep losses.

[edit] Liquidity risk

The market can stay irrational longer than

“ you can stay solvent.

”
—John Maynard Keynes

Arbitrage trades are necessarily synthetic, leveraged trades, as they involve a

short position. If the assets used are not identical (so a price divergence makes
the trade temporarily lose money), or the margin treatment is not identical, and
the trader is accordingly required to post margin (faces a margin call), the trader
may run out of capital (if they run out of cash and cannot borrow more) and go
bankrupt even though the trades may be expected to ultimately make money. In
effect, arbitrage traders synthesize a put option on their ability to finance
themselves.[2]

Prices may diverge during a financial crisis, often termed a "flight to quality";
these are precisely the times when it is hardest for leveraged investors to raise
capital (due to overall capital constraints), and thus they will lack capital precisely
when they need it most.[2]

[edit] Types of arbitrage

[edit] Merger arbitrage
Also called risk arbitrage, merger arbitrage generally consists of buying the stock
of a company that is the target of a takeover while shorting the stock of the
acquiring company.

Usually the market price of the target company is less than the price offered by
the acquiring company. The spread between these two prices depends mainly on
the probability and the timing of the takeover being completed as well as the
prevailing level of interest rates.

The bet in a merger arbitrage is that such a spread will eventually be zero, if and
when the takeover is completed. The risk is that the deal "breaks" and the spread
massively widens.

[edit] Municipal bond arbitrage

Also called municipal bond relative value arbitrage, municipal arbitrage, or
just muni arb, this hedge fund strategy involves one of two approaches.
Generally, managers seek relative value opportunities by being both long and
short municipal bonds with a duration-neutral book. The relative value trades may
be between different issuers, different bonds issued by the same entity, or capital
structure trades referencing the same asset (in the case of revenue bonds).
Managers aim to capture the inefficiencies arising from the heavy participation of
non-economic investors (i.e., high income "buy and hold" investors seeking tax-
exempt income) as well as the "crossover buying" arising from corporations' or
individuals' changing income tax situations (i.e., insurers switching their munis for
corporates after a large loss as they can capture a higher after-tax yield by
offsetting the taxable corporate income with underwriting losses). There are
additional inefficiencies arising from the highly fragmented nature of the
municipal bond market which has two million outstanding issues and 50,000
issuers in contrast to the Treasury market which has 400 issues and a single
issuer.

Second, managers construct leveraged portfolios of AAA- or AA-rated tax-exempt

municipal bonds with the duration risk hedged by shorting the appropriate ratio of
taxable corporate bonds. These corporate equivalents are typically interest rate
swaps referencing Libor or SIFMA[2] [3]. The arbitrage manifests itself in the form
of a relatively cheap longer maturity municipal bond, which is a municipal bond
that yields significantly more than 65% of a corresponding taxable corporate
bond. The steeper slope of the municipal yield curve allows participants to collect
more after-tax income from the municipal bond portfolio than is spent on the
interest rate swap; the carry is greater than the hedge expense. Positive, tax-free
carry from muni arb can reach into the double digits. The bet in this municipal
bond arbitrage is that, over a longer period of time, two similar instruments—
municipal bonds and interest rate swaps—will correlate with each other; they are
both very high quality credits, have the same maturity and are denominated in
U.S. dollars. Credit risk and duration risk are largely eliminated in this strategy.
However, basis risk arises from use of an imperfect hedge, which results in
significant, but range-bound principal volatility. The end goal is to limit this
principal volatility, eliminating its relevance over time as the high, consistent, tax-
free cash flow accumulates. Since the inefficiency is related to government tax
policy, and hence is structural in nature, it has not been arbitraged away.

[edit] Convertible bond arbitrage

A convertible bond is a bond that an investor can return to the issuing company in
exchange for a predetermined number of shares in the company.

A convertible bond can be thought of as a corporate bond with a stock call

option attached to it.

The price of a convertible bond is sensitive to three major factors:

• interest rate. When rates move higher, the bond part of a convertible bond
tends to move lower, but the call option part of a convertible bond moves
higher (and the aggregate tends to move lower).
• stock price. When the price of the stock the bond is convertible into moves
higher, the price of the bond tends to rise.
• credit spread. If the creditworthiness of the issuer deteriorates
(e.g. rating downgrade) and its credit spread widens, the bond price tends to
 move lower, but, in many cases, the call option part of the convertible bond
moves higher (since credit spread correlates with volatility).
Given the complexity of the calculations involved and the convoluted structure
that a convertible bond can have, an arbitrageur often relies on sophisticated
quantitative models in order to identify bonds that are trading cheap versus their
theoretical value.

Convertible arbitrage consists of buying a convertible bond and hedging two of

the three factors in order to gain exposure to the third factor at a very attractive
price.

For instance an arbitrageur would first buy a convertible bond, then sell fixed
income securities or interest rate futures (to hedge the interest rate exposure)
and buy some credit protection (to hedge the risk of credit deterioration).
Eventually what he'd be left with is something similar to a call option on the
underlying stock, acquired at a very low price. He could then make money either
selling some of the more expensive options that are openly traded in the market
or delta hedging his exposure to the underlying shares.

[edit] Depository receipts

A depository receipt is a security that is offered as a "tracking stock" on another
foreign market. For instance a Chinese company wishing to raise more money
may issue a depository receipt on the New York Stock Exchange, as the amount of
capital on the local exchanges is limited. These securities, known as ADRs
(American Depositary Receipt) or GDRs (Global Depositary Receipt) depending on
where they are issued, are typically considered "foreign" and therefore trade at a
lower value when first released. However, they are exchangeable into the original
security (known as fungibility) and actually have the same value. In this case
there is a spread between the perceived value and real value, which can be
extracted. Since the ADR is trading at a value lower than what it is worth, one can
purchase the ADR and expect to make money as its value converges on the
original. However there is a chance that the original stock will fall in value too, so
by shorting it you can hedge that risk.

[edit] Dual-listed companies

A dual-listed company (DLC) structure involves two companies incorporated in
different countries contractually agreeing to operate their businesses as if they
were a single enterprise, while retaining their separate legal identity and existing
stock exchange listings. In integrated and efficient financial markets, stock prices
of the twin pair should move in lockstep. In practice, DLC share prices exhibit
large deviations from theoretical parity. Arbitrage positions in DLCs can be set-up
by obtaining a long position in the relatively underpriced part of the DLC and a
short position in the relatively overpriced part. Such arbitrage strategies start
paying off as soon as the relative prices of the two DLC stocks converge toward
theoretical parity. However, since there is no identifiable date at which DLC prices
will converge, arbitrage positions sometimes have to be kept open for
considerable periods of time. In the meantime, the price gap might widen. In
these situations, arbitrageurs may receive margin calls, after which they would
most likely be forced to liquidate part of the position at a highly unfavorable
moment and suffer a loss. Arbitrage in DLCs may be profitable, but is also very
risky, see [3]. Background material is available at [4].
A good illustration of the risk of DLC arbitrage is the position in Royal Dutch Shell
—which had a DLC structure until 2005—by the hedge fund Long-Term Capital
Management (LTCM, see also the discussion below). Lowenstein
(2000) [4] describes that LTCM established an arbitrage position in Royal Dutch
Shell in the summer of 1997, when Royal Dutch traded at an 8 to 10 percent
premium. In total $2.3 billion was invested, half of which long in Shell and the
other half short in Royal Dutch (Lowenstein, p. 99). In the autumn of 1998 large
defaults on Russian debt created significant losses for the hedge fund and LTCM
had to unwind several positions. Lowenstein reports that the premium of Royal
Dutch had increased to about 22 percent and LTCM had to close the position and
incur a loss. According to Lowenstein (p. 234), LTCM lost $286 million in equity
pairs trading and more than half of this loss is accounted for by the Royal Dutch
Shell trade.

[edit] Private to public equities

The market prices for privately held companies are typically viewed from a return
on investment perspective (such as 25%), whilst publicly held and or exchange
listed companies trade on a Price to Earnings multiple (such as a P/E of 10, which
equates to a 10% ROI). Thus, if a publicly traded company specialises in the
acquisition of privately held companies, from a per-share perspective there is a
gain with every acquisition that falls within these guidelines. Exempli
gratia, Berkshire-Hathaway. A hedge fund that is an example of this type of
arbitrage is Greenridge Capital, which acts as an angel investor retaining equity in
private companies which are in the process of becoming publicly traded, buying in
the private market and later selling in the public market. Private to public equities
arbitrage is a term which can arguably be applied to investment banking in
general. Private markets to public markets differences may also help explain the
overnight windfall gains enjoyed by principals of companies that just did an initial
public offering.

[edit] Regulatory arbitrage

For more details on this topic, see Jurisdictional arbitrage.
Regulatory arbitrage is where a regulated institution takes advantage of the
difference between its real (or economic) risk and the regulatory position. For
example, if a bank, operating under the Basel I accord, has to hold 8% capital
against default risk, but the real risk of default is lower, it is profitable
to securitise the loan, removing the low risk loan from its portfolio. On the other
hand, if the real risk is higher than the regulatory risk then it is profitable to make
that loan and hold on to it, provided it is priced appropriately.

This process can increase the overall riskiness of institutions under a risk
insensitive regulatory regime, as described by Alan Greenspan in his October
1998 speech on The Role of Capital in Optimal Banking Supervision and
Regulation.

Regulatory Arbitrage was used for the first time in 2005 when it was applied by
Scott V. Simpson, a partner at law firm Skadden, Arps, to refer to a new defence
tactic in hostile mergers and acquisitions where differing takeover regimes in
deals involving multi-jurisdictions are exploited to the advantage of a target
company under threat.
In economics, regulatory arbitrage (sometimes, tax arbitrage) may be used to
refer to situations when a company can choose a nominal place of business with a
regulatory, legal or tax regime with lower costs. For example,
an insurance company may choose to locate in Bermuda due to preferential tax
rates and policies for insurance companies. This can occur particularly where the
business transaction has no obvious physical location: in the case of many
financial products, it may be unclear "where" the transaction occurs.

Regulatory arbitrage can include restructuring a bank by outsourcing services

such as IT. The outsourcing company takes over the installations, buying out the
bank's assets and charges a periodic service fee back to the bank. This frees up
cashflow usable for new lending by the bank. The bank will have higher IT costs,
but counts on the multiplier effect of money creation and the interest rate spread
to make it a profitable exercise.

Example: Suppose the bank sells its IT installations for 40 million USD. With a
reserve ratio of 10%, the bank can create 400 million USD in additional loans
(there is a time lag, and the bank has to expect to recover the loaned money back
into its books). The bank can often lend (and securitize the loan) to the IT services
company to cover the acquisition cost of the IT installations. This can be at
preferential rates, as the sole client using the IT installation is the bank. If the
bank can generate 5% interest margin on the 400 million of new loans, the bank
will increase interest revenues by 20 million. The IT services company is free to
leverage their balance sheet as aggressively as they and their banker agree to.
This is the reason behind the trend towards outsourcing in the financial sector.
Without this money creation benefit, it is actually more expensive to outsource
the IT operations as the outsourcing adds a layer of management and increases
overhead.

[edit] Telecom arbitrage

Main article: International telecommunications routes
Telecom arbitrage companies allow phone users to make international calls for
free through certain access numbers. Such services are offered in the United
Kingdom; the telecommunication arbitrage companies get paid an interconnect
charge by the UK mobile networks and then buy international routes at a lower
cost. The calls are seen as free by the UK contract mobile phone customers since
they are using up their allocated monthly minutes rather than paying for
additional calls.

Such services were previously offered in the United States by companies such as
FuturePhone.com.[5] These services would operate in rural telephone exchanges,
primarily in small towns in the state of Iowa. In these areas, the local telephone
carriers are allowed to charge a high "termination fee" to the caller's carrier in
order to fund the cost of providing service to the small and sparsely-populated
areas that they serve. However, FuturePhone (as well as other similar services)
ceased operations upon legal challenges from AT&T and other service providers.[6]

[edit] Statistical arbitrage

Main article: Statistical arbitrage
Statistical arbitrage is an imbalance in expected nominal values. A casino has a
statistical arbitrage in every game of chance that it offers—referred to as
the house advantage, house edge, vigorish or house vigorish.
[edit] The debacle of Long-Term Capital
Management
Main article: Long-Term Capital Management
Long-Term Capital Management (LTCM) lost 4.6 billion U.S. dollars in fixed income
arbitrage in September 1998. LTCM had attempted to make money on the price
difference between different bonds. For example, it would sell U.S. Treasury
securities and buy Italian bond futures. The concept was that because Italian bond
futures had a less liquid market, in the short term Italian bond futures would have
a higher return than U.S. bonds, but in the long term, the prices would converge.
Because the difference was small, a large amount of money had to be borrowed
to make the buying and selling profitable.

The downfall in this system began on August 17, 1998, when Russia defaulted on
its ruble debt and domestic dollar debt. Because the markets were already
nervous due to the Asian financial crisis, investors began selling non-U.S. treasury
debt and buying U.S. treasuries, which were considered a safe investment. As a
result the price on US treasuries began to increase and the return began
decreasing because there were many buyers, and the return on other bonds
began to increase because there were many sellers. This caused the difference
between the prices of U.S. treasuries and other bonds to increase, rather than to
decrease as LTCM was expecting. Eventually this caused LTCM to fold, and their
creditors had to arrange a bail-out. More controversially, officials of the Federal
Reserve assisted in the negotiations that led to this bail-out, on the grounds that
so many companies and deals were intertwined with LTCM that if LTCM actually
failed, they would as well, causing a collapse in confidence in the economic
system. Thus LTCM failed as a fixed income arbitrage fund, although it is unclear
what sort of profit was realized by the banks that bailed LTCM out.

[edit] Etymology
Look up arbitrage in Wiktionary, the free dictionary.
"Arbitrage" is a French word and denotes a decision by an arbitrator or arbitration
tribunal. (In modern French, "arbitre" usually means referee or umpire.) In the
sense used here it is first defined in 1704 by Mathieu de la Porte in his treatise "La
science des négocians et teneurs de livres" as a consideration of different
exchange rates to recognize the most profitable places of issuance and
settlement for a bill of exchange ("L'arbitrage est une combinaison que l’on fait de
plusieurs changes, pour connoitre [connaître, in modern spelling] quelle place est
plus avantageuse pour tirer et remettre".)[7]

[edit] See also

[edit] Types of financial arbitrage
• Arbitrage betting
• Covered interest arbitrage
• Fixed income arbitrage
• Political arbitrage
• Risk arbitrage
• Statistical arbitrage
 • Triangular arbitrage
• Uncovered interest arbitrage
• Volatility arbitrage
[edit] Related concepts
• Algorithmic trading
• Arbitrage pricing theory
• Coherence (philosophical gambling strategy), analogous concept
in Bayesian probability
• Efficient market hypothesis
• Immunization (finance)
• Interest rate parity
• Intermediation
• TANSTAAFL
• Value investing
[edit] Notes
1. ^ As an arbitrage consists of at least two trades, the metaphor is of
putting on a pair of pants, one leg (trade) at a time. The risk that one trade
(leg) fails to execute is thus 'leg risk'.
[edit] References
1. ^ See e.g. Shleifer, Andrei, and Robert Vishny, 1997, The limits of
arbitrage, Journal of Finance 52, 35-55.
Xiong, Wei, 2001, Convergence trading with wealth effects, Journal of
Financial Economics 62, 247-292.
Kondor, Peter, 2009. Risk in Dynamic Arbitrage: Price Effects of
Convergence Trading Journal of Finance 64(2),638-658,
2. ^ a b The Basis Monster That Ate Wall Street, D. E. Shaw & Co.
3. ^ de Jong, A., L. Rosenthal and M.A. van Dijk, 2008, The Risk and Return of
Arbitrage in Dual-Listed Companies, June 2008.[1]
4. ^ Lowenstein, R., 2000, When genius failed: The rise and fall of Long-Term
Capital Management, Random House.
5. ^ Ned Potter (2006-10-13). "Free International Calls! Just Dial ...
Iowa". http://abcnews.go.com/Technology/story?id=2560255. Retrieved
2008-12-23.
6. ^ Mike Masnick (2007-02-07). "Phone Call Arbitrage Is All Fun And Games
(And Profit) Until AT&T Hits You With A $2 Million
Lawsuit".http://techdirt.com/articles/20070207/123022.shtml. Retrieved
2008-12-23.
7. ^ See "Arbitrage" in Trésor de la Langue Française.
• Greider, William (1997). One World, Ready or Not. Penguin Press. ISBN 0-
7139-9211-5.
• Special Situation Investing: Hedging, Arbitrage, and Liquidation, Brian J.
Stark, Dow-Jones Publishers. New York, NY 1983. ISBN 0870943847; ISBN
9780870943843
[edit] External links
• What is Arbitrage? (About.com)
• ArbitrageView.com – Arbitrage opportunities in pending merger deals in
the U.S. market
 • Information on arbitrage in dual-listed companies on the website of Mathijs
A. van Dijk.
• What is Regulatory Arbitrage. Regulatory Arbitrage after the Basel ii
framework and the 8th Company Law Directive of the European Union.
Retrieved from "http://en.wikipedia.org/wiki/Arbitrage"
Categories: Financial markets
Hidden categories: Articles containing French language text
Personal tools
• New features
• Log in / create account
Namespaces
• Article
• Discussion
Variants
Views
• Read
• Edit
• View history
Actions
Search

Navigation
• Main page
• Contents
• Featured content
• Current events
• Random article
• Donate
Interaction
• About Wikipedia
• Community portal
• Recent changes
• Contact Wikipedia
• Help
Toolbox
• What links here
• Related changes
• Upload file
• Special pages
• Permanent link
• Cite this page
Print/export
• Create a book
• Download as PDF
• Printable version
Languages
 • ‫العربية‬
• Česky
• Deutsch
• Eesti
• Ελληνικά
• Español
• ‫فارسی‬
• Français
• िहनदी
• Bahasa Indonesia
• Íslenska
• Italiano
• ‫עברית‬
• Nederlands
• 日本語
• Norsk (bokmål)
• Polski
• Português
• Русский
• Suomi
• Svenska
• Türkçe
• 中文
• This page was last modified on 9 September 2010 at 22:29.
• Text is available under the Creative Commons Attribution-ShareAlike
License; additional terms may apply. See Terms of Use for details.
Wikipedia® is a registered trademark of the Wikimedia Foundation, Inc., a non-
profit organization.
• Contact us
• Privacy policy
• About Wikipedia
• Disclaimers

•
This E-mail is confidential. It may also be legally privileged. If you are not the
addressee you may not copy, forward, disclose or use any part of it. If you have
received this message in error, please delete it and all copies from your system
and notify the sender immediately by return E-mail. Internet communications
cannot be guaranteed to be timely, secure, error or virus-free. MCB Bank does not
accept liability for any errors or omissions.

--Forwarded Message Attachment--

From:
Subject: Foreign Exchange Market
Date: Fri, 24 Sep 2010 16:35:09 +0500

Foreign Exchange Market

1. CHARACTERISTICS OF FE
MARKET
Barter exchange (Double
coincidence of wants): In the
foreign exchange market, for
anybody wanting to sell
dollars to get British pound,
Barter Exchange
there must be someone else
wanting to sell the pound for
the dollar at the same
exchange rate (like in barter
exchange).

Role The FE market performs an

international clearing
function by bringing two
parties wishing to trade
currencies at agreeable
exchange rates.

The FE market takes place

between dealers and brokers
in financial centers around
the world. During the hours
of business common to
different time zones, they
rapidly exchange shorthand
messages expressing their
bids for different currencies.

To make a profit on FE
 maneuvers, a trader or
broker has to make quick
decisions correctly. Foreign
exchange traders lead an
exciting and hectic life, and
the pressure often shortens
many careers.

The fastest possible

communications are used.
Before the trans-Atlantic
cable was laid in 1865 by
Cyrus West Field (after
many failed attempts),
somebody wanting to
exchange dollars for pounds
often had to wait the time
required for a roundtrip
voyage to clear up the
transaction. Modern
telephone links have reduced
the transaction costs on
foreign exchange to near
zero for large transactions.

Currencies of the world

2. Origin of Money
Inside the lid, there is a Chinese
character written below. Cowries were
used as money during the Shang dynasty
(1600 - 1046 BC)
3. The advantages of the Foreign Exchange
Market
Volume The daily volume of business dealt
with on the foreign exchange markets
in 1998 was estimated to be over $2.5
trillion dollars.

(Daily volume on New York Stock

Exchanges is about $20 billion)
Today (2006) it may be about $5
trillion dollars. The daily volume of
the foreign exchange market in North
America in October 2005 was about
 $440 billion.

The Foreign Exchange market

expanded considerably since
President Nixon closed the gold
window and currencies were left
afloat vis-á-vis other currencies and
speculators could profit from their
transactions.

Until recently, this market was used

mostly by banks, who fully
appreciated the excellent
Who opportunities to increase their profits.
Today, it is accessible to any investor
enabling him to diversify his
portfolio.

traded (i) dollar is still the dominant

Currencies currency.
(ii) The emergence of Yen as a major
currency, and

(iii) new Euro, in addition to the

Dollar beside many other currencies,
and the frequent fluctuations in
relative value of these currencies
provide a great opportunity to
generate substantial profits.

(iv) RMB: Chinese Renminbi is

convertible on current account, but
 not on capital account. When it
becomes fully convertible, which is
not likely to occur until 2020 or later,
it will fundamentally affect the
foreign exchange market due to its
sheer volume.

The foreign exchange market

operates 24 hours a day permitting
When intervention in the major
international foreign exchange
markets at any point in time.

4. Some FE Customs
Although there is an exchange rate
between the domestic currency and
every other currency, most FE
transactions involve only a small
traded number of international currencies.
currencies Average daily transactions in 1998
was over $2.5 trillion. $637B
(London), $351B (New York),
$149B (Tokyo).

Euro
Before the single currency euro was
launched in 2002, the composition of
foreign currency transactions in the
New York market in 1985 was as
 follows: Mark 32%, Pound 23%,
Canada $ 12%, Yen 10%, Swiss
Franc 10%, others 13%.

The introduction of euro in 2002

dramatically changed the
composition of these foreign
currencies as most of European
currencies were no longer circulated.
The foreign exchange markets were
handling over $450 billion per day
through New York, London and
Frankfurt. (most market economies
have less GNP). Today it is
estimated to be more than $5T a day.

Selling The exchange rate is the domestic

price price of a foreign currency. The FE
quotations list selling price in dollars
or foreign currency per dollar.
The selling price refers to the price
at which a large customer could have
bought the currency from the
dealers. The buying price at which
one could have sold foreign currency
to the dealers is normally 0.1%
below the selling price, which
represents the commission of FE
dealers or banks. This is called
interbank trading as it occurs usually
between foreign exchange dealers in
different banks in major financial
 centers. Obviously, the "retail" rates
for corporate customers are less
favorable than the "wholesale" rates.

This spread can be higher in foreign

exchange markets other than New
York/London, and also in exchange
crisis, and in rarely traded
Spread
currencies. Because the market
participants know this customary
spread, usually selling prices are
published.

Spot rates (i) For most currencies, only a spot

rate is quoted. Spot exchange is
foreign exchange for immediate
delivery that is used for international
payments (for imports and
investment). The daily quotations are
for bank (cable) transfers. While
transactions between these banks are
instantaneous, these funds become
available for use by customers 1-2
working days after the purchase.
(ii) Transactions agreed on Monday
will result in payments on
Wednesday. Those agreed on
Thursday will be available on
Monday. Canadian/US dollar
business is cleared in one day
(because Toronto and New York are
 in the same time zone).

(iii) Some New York banks maintain

2 shifts (one arriving at office at 3
am when London and Frankfurt are
open). Large New York banks also
have branches in Tokyo, Frankfurt,
and London. Thus, they are in
contact with all financial centers 24
hours.

(iv) When a FE dealer or broker

quotes a price on the telephone, he
can be held to it for only a few
seconds (It used to be up to 1
minute). Dealers may quote different
prices to different customers. Prices
change throughout the day.
Bluffing/counterbluffing for a large
sum of FE. For average customers, it
does not pay to get more than one
quote.

Buying and selling rates for bank

notes may be listed. Prices do not
change throughout the day. Selling
Bank price for BN may be higher/lower
notes than the selling price for Cable
transfers. The spread is much larger
than 0.1% for cable transfers, and
may go up to 5-10%.
 forward rates are for currency to be
delivered 30, 90 or 180 days later at
Forward the known price on a given day.
rates Forward rates are available for major
international currencies.

Currency futures markets were

established by Chicago Mercantille
exchange in 1972. Futures prices are
Currency for contracts applicable to a specific
futures calendar dates (Third Wednesday of
June, September, December and
March).

5. Participants of the Foreign Exchange

markets
Retail They are importers/exporters of
customers goods, services and financial assets
(stocks/bonds).

They are most numerous.

They buy and sell FE for transaction

purposes.

These do not usually trade

currencies one another because it is
difficult to match double
coincidence of wants. Instead they
 go to a commercial bank for the
transactions.

Foreign (i) FE Dealers are large

Exchange commercial banks, which buy and
dealers sell FE. Specifically, they are the
international departments of large
commercial banks in the financial
centers of the world: London, New
York, Tokyo, zurich, Frankfurt,
Paris, Singapore, Hong Kong,
Toronto.

In New York City, there are about

100 such banks.

(ii) Large banks outside the center

also participate through their
affiliates.

(iii) Small regional banks do not

directly participate in the FE
market. But to meet their customers'
FE need, they deal with
correspondant banks. Almost
14,000 commercial banks maintain
corresponent relationship with FE
dealers.

(iv) FE dealers typically maintain a

trading room equipped with
telephones and telex machines.
 They ususally communicate directly
with the trading rooms of banks in
other centers. They go through a
broker when dealing with other
banks in the same center. They are
exposed to FE risks.

These are wholesale dealers

between FE dealers. FE dealers may
develop shortage/surplus. Then they
go to brokers.Brokers do not take
open positions in the FE market.
FE brokers
There are 8 brokers in New York,
and less than 100 in the U.S. They
usually specialize in a few
currencies, and earn commission =
1/10 of 1% - 1/8 of 1%.

Central participate (i) to facilitate

Banks Treasury's transactions, and (ii) to
prevent or effect a change in the
value of their currency.

(i) in the US, Federal Reserve Bank

of NY acts as agent for the entire
Federal Reserve System and the
Treasury Department.

(ii) it usually try to conceal its

intervention. It may requres an
obscure bank in Midwest to place
 an order in the New York market.

(iii) Sometimes it tries to publicize

its buying intent.

numerous, but they participate

Speculators
through FE dealers.

5. Three Traders
Videotape World Poker Championship: Cards
(June 4, are shown only to the viewers.
1985) Apparently, viewers cannot convey
any message to the players. The
winner's prize is over $2 million.
With sharp minds, the players can
incorporate all the information on
the displayed cards and calculate
the probability of a desired card. In
the case of poker, there are only 52
possible cards. Accordingly, bright
individuals can compute the
probabilities of winning of his own
and competing players. These
probabilities of winning are almost
instantaneously computed for TV
viewers.

Since so many things can possibly

affect the probability that a
currency will rise against another,
 computer programs or formulas for
the price of a given stock or
currency to rise cannot be devised.
Some investment companies will
claim they have developed a certain
formula or program to buy and sell
currencies (or stocks), but they are
doomed. If a particular method
brings profits to the investor, more
people will invest money into that
formula, thereby driving the prices
of currencies/stocks downward and
raising the prices of those they are
selling, eventually eliminating
profits.

Instead of relying on a fixed

formula, currency dealers can
incorporate all the available
information about the currency
markets and other news on world
events which affect the currency
values.

Ronnie Swiss, lives in New York

Schlaefer long term speculator (he holds
foreign currencies even over night)
(speculator) has a bunch of medical doctors who
invests a minimum of $0.5 million.
13 rich investors, around the world
50% profit rate in 1984.
 management fee = fixed.
performance fee = 20- 25% once a
year.
made many mistakes of missing the
moment to sell mark, but breaks
even at the end of the day

Richard 31 years old, works for London

Hill Barclay. gets No commission.
The majority of traders are 20 - 35
years old.
Chris Pablo: boss. A sterling dealer,
old. Traders must concentrate when
working. People get nervous.
Traders earn fixed salary. No
commission, but pushed aside if
when a big mistake is made.
Hill finds out that Russians
(Moscow) are buying £ with mark,
jumps on the bandwagon by buying
£, thereby raising the price a little
and then sells it later.

Hill bought and sold 750 million £

and profited π = $160,000
(£91,400) that day. (one day's
interest at 1% is £20547). The rate
of return is about 8% per year.

U: = you, pls = please

 Barclay: 8 dealers, made $150
million profit, 1984
($.5 million a day) Today, their
profits from foreign exchange
transactions would be over $1
million a day.

(works for Chemical bank, Hong

Kong) sold £20 million, made
($20,000 morning) pounds he
bought worth $30,000 less (from
Richard Hill).
Salary = $40,000 + 3%
commission.

When selling a large amount of FE,

William people notice it and price falls. To
Wong avoid it, William Wong requests
the assistance of other dealers and
sell £ simultaneously.

At the end of the day, he bought

and sold 120 million £, with profit
= $30,000 (£17,142), which is
equivalent to one day's interest on
the principal at 5.2 % per year.

6. Exchange Arbitrage
Definition Exchange arbitrage involes the
 simultaneous purchase and sale of a
currency in different foreign
exchange markets. Thus, arbitragers
take a closed position. (No risk)

Arbitrage becomes profitable

whenever the price of a currency in
one market differs from that in
another market.

Suppose the pound quoted in NY is

$1.75, but pound quoted in London
is $1.78. Then an arbitrager in NY
and his partner in London can take
the following steps:
How
(a) buy 10 M pounds in NY: cost =
$17.5 M

(b) sell 10 M pounds in London:

revenue = $17.8 M

(c) profit = $300,000 less the cost of

telephone, cable transfer.The supply
of pound shrinks in NY, increases in
London.

Effect of wipe out the spread in exchange

arbitrage rates between FE markets.

7. Currency Speculation
 Speculators assume an open position, i.e., take
Speculat
risk in the FE markets. Their intention is to
ion is
make windfall gains from the fluctuations in
risky
the FE markets.

When speculators expect a rise in the

When to
exchange rate in the future, they go long (buy
buy?
that currency), i.e., buy FE if ESt+1 > St.

They go short by selling FE if they expect a

when to fall in the exchange rate,
sell? sell FE if ESt+1 < St.

in the forward market for pound,

Forward if F90 > ES90, then sell forward pound
market
if F90 < ES90, then buy forward pound.

Speculation under fixed exchange rate system

speculati is destabilizing. If dollar is weak, the
on is speculators correctly expect that dollar will be
destabili depreciated soon and sell dollar. This makes it
zing harder for government to defend its exchange
rate.
Currency
instabilit
y

What President Nixon once tried to punish these

Nixon specualtors by dumping gold, effectively
did raising the official price of gold, but
eventually he gave up. On August 15,
1971, President Nixonannounced:

In recent weeks, the speculators have been

waging an all-out war on the American dollar.
The strength of a nation's currency is based on
the strength of that nation's economy-and the
American economy is by far the strongest in
 the world. Accordingly, I have directed the
Secretary of the Treasury to take the action
necessary to defend the dollar against the
speculators.

I have directed Secretary Connally to suspend

temporarily the convertibility of the dollar
into gold or other reserve assets,except in
amounts and conditions determined to be in
the interest of monetary stability and in the
best interests of the United States.

8. Forward Exchange Rate

Definition Forward exchange markets deal in
promises to sell or buy foreign
exchange at a specified rate, and at a
specified time in the future with
payment to be made upon delivery.
These promises are known as
forward exchange and the price is the
forward exchange rate. Forward
exchange markets do not operate
during periods of hyperinflation.
The forward exchange market
resembles the futures markets found
in organized commodity markets,
such as wheat and coffee. The
primary function of forward market
is to afford protection against the risk
 of fluctuations in exchange rates.

Forward markets are most useful

(i) under flexible exchange rate
when system and if there are significant
forward exchange variations,
markets are
(ii) under fixed exchange rate
active
system, if there is a strong possibility
of devaluation/revaluation,

(i) it cannot function when exchange

control is imposed.
Non
operational (ii) it cannot function during perids
of hyperinflation.

9. Interest Parity Theory (Keynes)

Wh It is John Maynard Keynes' theory of how
at is forward rates are determined.
IPT?
When short term interests are higher in one market
than in another, investors will be motivated to
shift funds between markets, say New York and
London.

Investors borrow (or buy) a low interest currency

 and lend the same amount in a high interest
currency. This is called carry trade. There is
roughly a 5% difference in the interest rates
between Japan and the US. To make profits from
differeing interest rates, investors must convert,
for example, dollars (a low interest currency) into
pound sterling (a high interest currency) for
investment in London. However, they would be
exposed to an exchange risk. If the exchange rate
is stable, the investors gain the interest
differential, (i - i*), by shifting funds from New
York to London.

If pound appreciates during the investment

period, the foreign investors will reap additional
gain in the change in the exchange rate. However,
if pound depreciates, they will experience an
exchange loss. The exchange loss may partially or
more than offset the gain in the interest income.

To avoid this exchange loss, dollar investors

want cover against the exchange loss by selling
pound forward. The amount of forward pound to
sell is equal to the purchase of spot pound plus the
interest earned in London. This practice is
calledinterest arbitrage. Interest arbitrage links
the two national money markets and the forward
market.

Exa Assume: a US investor has A dollars to invest,

mple either in New York or in London. The annual
interests in the US and the UK are 8% and 12%,
 respectively. The quarterly interest rates in the US
and UK are then 2% and 3%, respectively.

(1) Invest in New York for 90 days.

$1M(1 + .02) = $1.02M

(2) Invest in London

£t=0 = $1M/spot = $1M/1.5 = £666,667.

If St=90 = St=0, then investing overseas is better

($10,000 more return).
Do
nothi If St=90 = 1.65 (£ rose 10%), then
ng $10,000 (interest gain) + $103,000 (appreciation
(take of £) = $113,000 (foreign investment is definitely
risk) better).

If St=90 = 1.35 (£ fell 10%), then

$10,000 (interest gain) - $103,000 (depreciation of

£) = - $93,000.

Most investors would rather avoid this exchange

risk.